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Saturday, September 13, 2014

Friday's release of disappointing August payroll numbers should have been a jarring wake-up call warning Wall Street that the economy has been treading on thin ice. Instead the alarm clock was stuffed under the pillow and Wall Street kept sleeping. The miss was so epic in fact (the 142,000 jobs created was almost 40% below the consensus estimate) that the top analysts on Wall Street did their best to tell us that it was all just a bad dream. Mark Zandi of Moody's reacted on Squawk Box by saying "I don't believe this data." The reliably optimistic Diane Swonk of Mesirow Financial told Reuters the report "sure looks like a fluke, not a trend".

But the opinions of those that really matter, the central bankers in charge of the global economy, are likely taking the report much more seriously. Given that this is just the latest in a series of moribund data releases, such as news today that U.S. mortgage applications have fallen to the lowest levels in 14 years, caution is justified. Unfortunately very little good comes from central bank activism. Recent statements from Fed officials across the United States and recent actions from ECB president Mario Draghi reveal their growing resolve to fight too low inflation, which they believe is the biggest threat to recovery. There are many things that are contributing to the global woes. But low prices are not high on the list.

Since the markets crashed in 2008, central banks around the world have worked feverishly to push up the prices of financial assets and to keep consumer prices rising steadily. They have done so in the official belief that these outcomes are vital ingredients in the recipe for economic growth. The theory is that steady inflation creates demand by inspiring consumers to spend in advance of predictable price increases. (The flip side is that falling prices "deflation," strangles demand by inspiring consumers to defer spending). The benefits of inflation are supposed to be compounded by rising stock and real estate prices, creating a wealth effect for the owners of those assets which subsequently trickles down to the rest of the economy. In other words, seed the economy with money and inflation and watch it grow.

Thus far the banks have been successful in creating the bubbles and keeping inflation positive, but growth has been a no show. The theory says the growth is right around the corner, but like Godot it stubbornly fails to show up. This has been a tough circle for many economists to square.

Two explanations have emerged to explain the failure. Either the model is not functioning (and higher inflation and asset bubbles don't lead to growth) or the stimulus efforts thus far, in the form of zero percent interest rates and quantitative easing, have been too timid. So either the bankers must devise a new plan, or double down on the existing plan. You should know where this is going. The banks are about to go "all in" on inflation.

Despite their much ballyhooed "independence", central bankers have proven that they operate hand in glove with government. They are also subject to all the same political pressures and bureaucratic paralysis. There is an unwritten law in government that when a program doesn't produce a desired outcome, the conclusion is almost never that the program was flawed, but that it was insufficient. Hence governments continually throw good money after bad. The free market discipline of cutting losses simply does not exist in government.

This is where we are with stimulus. Six years of zero percent interest rates and trillions and trillions of new public debt have failed to restore economic health, but our conclusion is that we just haven't given it enough time or effort. My theory is a bit different. Maybe zero percent interest rates and asset bubbles hinder rather than help a real recovery. Maybe they resurrect the zombie of a failed model and prevent something viable and lasting from gaining traction? This is a possibility that no one in power is prepared to consider.

But what if they succeed in getting the inflation, but we never get the growth? What if we are headed toward stagflation, a condition that in the late 1970s gripped the U.S. more tightly than Boogie Fever? It may come as a surprise to the new generation of economists, but high inflation and high unemployment can coexist. In fact, the two were combined in the 70s and 80s to produce "the Misery Index." But according to today's economic thinking, the Index should not be possible. Inflation is supposed to cause growth. If unemployment is high they say there is no demand to push up prices. But it's the monetary expansion that pushes prices up, not the healthy job market.

The tragedy is that if the policy fails to produce real growth, as I am convinced it will, the price will be paid by those elements of society least able to bear it, the poor and the old. Inflation and stagnation mean lost purchasing power. The rich can mitigate the pain with a rising stock portfolio and more modest vacation destinations. But they won't miss a meal. Those subsisting on meager income will be hit the hardest.

Many economists are now trying to make the case that the United States had hit on the right stimulus formula over the past few years and is now reaping the benefit of our bold monetary experimentation. They continue the argument by saying Europe and Japan were too timid to implement adequate stimulus and are now desperately playing catch up. But this theory is false on a variety of fronts. First off, the U.S. is not recovering but decelerating. Annualized GDP in the first half of 2014 has come in at just a shade over one percent, which is lower than all of 2013, which itself was lower than 2012. The unemployment rate is down, but labor participation is at a 36-year low, and wages are stagnant. We have added more than $5 trillion in new public debt, but very little to show for it. We are not the model that other countries should be following but a cautionary tale that should be avoided.

It is also spectacularly wrong to assume that the problems in Europe and Japan can be solved by a little more inflation. Higher prices will just be a heavier burden for European and Japanese consumers, not an elixir that revitalizes their economies. The problems in Europe, Japan and the U.S. all have to do with an oppressive environment for savings, investment, and productivity that is created by artificially low interest rates, intractable budget deficits, restrictive business regulation, antagonistic labor laws, and high taxes. Since none of the governments of these countries have the political will to tackle these problems head on, they simply hope that more monetary magic will do the trick.

So as the Fed, the ECB, the Bank of Japan, and all the other banks that follow suit, push all their chips into the pot and hope that a little more inflation will save us from the abyss, we can wish them luck. It's going to take a miracle.

Thursday, September 11, 2014

I feel confident that if you handed me a stack of market data combined with the operating statements of a commercial building over the past few years I can provide you a detailed explanation for the building's value.

When it comes to putting a value on Facebook, I have no idea. If you'd like the perspective of someone that has little understanding of the technology sector, here are my thoughts:

The market is gaga over the prospect of social media advertising. I've never been on Facebook, so maybe I do not understand, but are all these people around the world clicking on the advertisements and purchasing products? I have gotten to the point where I completely tune out the advertisements that are on a page.

It seems to me that "page views" have become the new "eyeballs" (the term investors used to measure value during the late 1990's technology bubble). Will companies continue to push more money into online advertising if the economy slows and their revenues fall? It's possible that when companies have to decide where to put cash in a rational manner they may stop to ask how much of the social media advertising is generating real sales for their products. Right?

Anyway, Facebook crossed the $200 billion valuation mark this week. I have no intention of purchasing the stock, and I'll probably look like an idiot when it hits a $400 billion valuation in 6 months.

Today we're going to strip out the value metrics and just look at one side of the equation; price. We'll be using charts put together by the excellent financial site; A Wealth Of Common Sense.

A large part of the reason why the U.S. market is relatively overpriced vs. the rest of the world.....is simply because the price has risen far more than other markets (remember price is half the equation). As we know, the average investor is naturally drawn to markets that have recently performed better than others like mosquitoes are drawn to a bug zapper.

The following chart shows the S&P 500 (the U.S. stock market), which has climbed well past its 2007 high and has been rising relentlessly for the better part of three years. It is where everyone in America wants to invest (see How The Home Bias Phenomenon Impacts Investors) and many speculators outside the U.S. want to invest right now.

The next charts show why there is relative value to be found outside the United States; these markets have not risen as relentlessly the past few years and have not crossed back above their 2007 highs.

Emerging Market Stocks:

European Stocks:

Asian Stocks:

Latin American Stocks:

The direction you believe these markets will move in the future depends on how you think the global economy and financial markets will behave in the years ahead. If you believe the global economy is just beginning to build up speed and will continue to expand in the years ahead, then there is an argument to be made to add positions to markets outside the United States which need to "catch up" in price performance.

If you believe the global economy will slow in the years ahead, you may want to consider exiting a portion of your global stock market portfolio and adding more cash or dry powder for a potential market decline. Under this scenario, in a worldwide sell-off, U.S. stocks would "catch down" to global stock markets and commodities (I am in this camp).

Under either scenario, based on relative value, an investor should not be holding the largest percentage of their stock holdings in U.S. stocks. If you are a momentum chaser, then the U.S. stock market is ideal because it has reached the euphoric blow off stage. If you are a value investor, then you should be exiting the U.S. market as quickly as possible.

The last bonus chart combines commodities and emerging market stocks. As you can see, they have tracked together over the past two decades mainly because emerging market countries are commodity producers and exporters. As commodity prices rise it positively impacts the revenue those countries receive. Click for larger image:

There has been a divergence over the past few months with emerging market stocks performing well while commodities have stagnated or declined.

You can look at this this divergence the same way we did for U.S. stocks vs. the world above. If you believe the global economy will grow at a faster pace in the years ahead, then commodities should "catch up" to the relative out performance of emerging market stocks.

If you believe the global economy will slow, then commodities are ahead of the curve on emerging market stocks which will soon "catch down."

I am somewhere in between. The largest position I continue to add to my portfolio is cash, while I layer in a smaller percentage of extremely sold off and hated commodities (mainly silver, agriculture grains, gold stocks and uranium stocks). My hope is that emerging markets "catch down" so I can use some of the dry powder in cash to enter those markets. The U.S. market is so far away from being even remotely close to undervaluation that there is no need to even pay attention to those stocks unless some enormous market crash brings them back down to earth (that is coming, so don't completely forget about them).

If you live in the United States, do your absolute best to think of the markets as a global financial environment. Do not let your mind wander back into the natural state of home bias.

Tuesday, September 9, 2014

Mebane Faber, author of one of the year's best books; Global Value, put together the chart below ranking stocks around the world from least expensive to the most expensive. He averaged the CAPE P/E ratio, dividends, book values and cash flows.

The United States is the fourth most expensive stock market in the world using this average (third most expensive using only CAPE). Does this mean that I would prefer to own a broad basket of stocks in Greece, Austria, Hungary, Italy, Russia, Portugal, ect. vs. a broad basket of stocks in the United States?

Yes.

Although I'm not currently buying stocks or bonds in any markets around the world, if we move back toward some sort of risk off movement ever again in my lifetime then I will purchase some of the more inexpensive stocks in the most inexpensive countries.

For more on this topic, see the presentation below that Faber recently gave to a team at Google on finding value globally:

Monday, September 8, 2014

We'll cover the ECB's trillion dollar announcement and the implications on the global financial system and economy in depth this week, but first, let's quickly review just how much a trillion dollars is:

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and but she will never sit down on a cold one either."

- Mark Twain

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait."

- Charlie Munger

"Live as if you were to die tomorrow. Learn as if you were to live forever."

- Gandhi

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel."

- Jim Rogers

"Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

- James Grant

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

- Ben Bernanke, March 2007

"Everything that needs to be said has already been said. But since no one was listening, everything must be said again."

- Andre Gide

"When people are getting richer and richer but they're not actually producing anything, it can't end well."

- Louis CK

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could."

- Rudiger Dornbusch

"I don't write about what I know. I write to find out what I know."

- Patricia Hampl

"Chains of habit are too light to be felt until they are too heavy to be broken."

- Warren Buffett

"Everyone has a plan until they get punched in the mouth."

- Mike Tyson

"Interest on the debt grows without rain."

- Yiddish Proverb

"You can have comfort, or you can have value. You cannot have both."

- Jim Grant

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

-Ludwig von Mises

"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

- Howard Marks

"Whenever you find yourself on the side of the majority, it is time to pause and reflect."

-Mark Twain

"None are more hopelessly enslaved than those that falsely believe they are free."

-Goethe

"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

-John Coumarianos

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

-Jean Monnet

Requiring a central bank to print money to increase government's purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.

- Alan Greenspan

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"Do you want to sell sugared water for the rest of your life? Or do you want to come with me and change the world?"

-Steve Jobs

"I'd be a bum on the street with a tin cup if the markets were always efficient."

-Warren Buffett

"The market can stay irrational longer than the investor can stay solvent."

- Keynes

"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

-Ayn Rand, 1974

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function."

- F. Scott Fitzgerald

"All our life, so far as it has definite form, is but a mass of habits - practical, emotional, and intellectual - systemically organized for our weal or woe, and bearing us irresistibly toward our destiny, whatever the latter may be."

-William James

"Men it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

- Stephen Hawkings

"Give me control of a nations money supply, and I care not who makes it's laws."

- Amschel Rothchild

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

- Sigmund Freud

Many of life's failures are people who did not realize how close they were to success when they gave up.